Contagion and Excess Correlation in Credit Default Swaps

This paper documents an increase in the correlation of credit default swap (CDS) spread changes during the credit crisis and investigates the source of that increase. One possible explanation is that correlations increased because fundamental values became more correlated during the crisis. Alternatively, correlations may have increased because of contagion, rather than because of an increase in the correlation of fundamental values. I find that fluctuations in fundamental credit risk account for only a small fraction of the increase in correlation. Furthermore, I find no evidence that correlations increased due to liquidity or counterparty risk. Lastly, I show that a systematic re-pricing of credit risk, as evidenced by variations in the default risk premium, amplified correlations during the crisis.